Low-Volatility Indexing Continues to Evolve

NEW YORK ( TheStreet) -- The reduced-risk, low-volatility space continues to grow, with the latest member of the club being the VelocityShares Equal Risk Weighted Large Cap ETF ( ERW).

The big idea is to modify the S&P 500 such that each constituent holding contributes the same amount of risk to the new fund.

The model employed by VelocityShares to create the index is proprietary but the methodology has to do with employing both historical and implied volatilities.

The lead fund in this space is the PowerShares S&P 500 Low Volatility Portfolio ( SPLV), which started trading two years ago. SPLV has performed well and attracted almost $5 billion in assets. As noted when SPLV first started trading, it has a very large 29% weighting to the utilities sector because SPLV simply takes the companies with the lowest volatility from the S&P 500.

Utilities are interest rate-sensitive because their yields tend to become less attractive as bond yields increase.The market saw this in May when rates spiked and SPLV went down 7.34% which was more than 6.6% drop for SPDR S&P 500 ( SPY). That might not seem like much of a difference but the idea is that SPLV will be less volatile. But that was not the case in that instance.

One objective of ERW's process is to avoid that kind of sector concentration. The largest sector in ERW is health care at 16% compared to that sector having a 13% weight in the S&P 500. The financial sector has a 15% weighting in ERW followed by 14% in tech and 14% in consumer discretionary. These weightings are sufficient to avoid the sector concentration that threatens SPLV.

Another objective to the construction of the fund is to reduce correlation among the holdings to further damp risk. Again, where the model is proprietary there is not a lot of information on the specifics of how this is achieved but the concept is sound. If a portfolio owns only two stocks that are both very volatile but have a very low correlation to each other, then the combo can have a less volatility than a broad index.

The fund might be giving a glimpse of how this works in practice with its two largest holdings; Chicago Mercantile Exchange ( CME) and Monster Beverage ( MNST), which each have about a 3.9% weight in the fund. Yahoo! Finance reports CME has a beta of 1.11 and that MNST has a beta of negative 0.29. In the trailing 12 months the stocks have looked nothing like the broad market, with CME going up 44% while MNST has dropped 2% versus a 24% increase for the S&P 500.

Embedding these sorts of offsets, if that is the intention, should help to smooth out the ride for fund holders, which is the big idea at work here.

It might be difficult for investors to embrace ERW because they won't know precisely how the fund is constructed. That a fund has a proprietary process is not in itself a negative.

A little over one year ago the Alpha Clone ETF ( ALFA) launched with arguably more secrecy. ALFA is constructed by combing through 13-F filings of disclosed positions by hedge funds. ALFA doesn't disclose how stocks are chosen for inclusion, the process to determine how the stocks are weighted or even what hedge funds are being tracked.

But the fund came with volumes of research to say the methodology works and so far, admittedly just 14 months of trading, ALFA is up 40% compared to a gain of 33% for the S&P 500.

The objective for ERW is not necessarily to outperform a huge broad market rally. If funds that seek some sort of reduced volatility or reduced risk outcome are going to add any value, it will be over a longer period of time. As is often the case with this space, ERW will not be a success or a failure six months from now.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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